Archive for the ‘Liquidity’ category

RISKVIEWS recently got the material below in an email. This material seems quite educational and also somewhat amusing. The authors keep pointing out the extreme variety of actual detailed approach from any single theory in the academic literature.

For example, the table following shows a plot of Required Equity Premium by publication date of book.

You get a strong impression from reading this book that all of the concepts of modern finance are extremely plastic and/or ill defined in practice.

RISKVIEWS wonders if that is in any way related to the famous Friedman principle that economics models need not be at all realistic. See post Friedman Model.

===========================================

Book “Valuation and Common Sense” (3rd edition). May be downloaded for free

The book explains the nuances of different valuation methods and provides the reader with the tools for analyzing and valuing any business, no matter how complex. The book has 326 tables, 190 diagrams and more than 180 examples to help the reader. It also has 480 readers’ comments of previous editions.

The book has 36 chapters. Each chapter may be downloaded for free at the following links:

A framework for estimating liquidity risk capital for a bank

Capital estimation for Liquidity Risk Management is a difficult exercise. It comes up as part of the internal liquidity risk management process as well as the internal capital adequacy assessment process (ICAAP). This post and the liquidity risk management series that can be found at the Learning Corporate Finance blog suggests a framework for ongoing discussion based on the work done by our team with a number of regional banking customers.

By definition banks take a small Return on asset (1% – 1.5%) and use leverage and turnover to scale it to a 15% – 18% Return on Equity. When market conditions change and a bank becomes the subject of a name crisis and a subsequent liquidity run, the same process becomes the basis for a death chant for the bank. We try to de-lever the bank by selling assets and paying down liabilities and the process quickly turns into a fire sale driven by the speed at which word gets out about the crisis.

Figure 1 Increasing Cash Reserves

Reducing leverage by distressed asset sales to generate cash is one of the primary defense mechanisms used by the operating teams responsible for shoring up cash reserves. Unfortunately every slice of value lost to the distressed sale process is a slice out of the equity pool or capital base of the bank. An alternate mechanism that can protect capital is using the interbank Repurchase (Repo) contract to use liquid or acceptable assets as collateral but that too is dependent on the availability of un-encumbered liquid securities on the balance sheet as well as availability of counterparty limits. Both can quickly disappear in times of crisis. The last and final option is the central bank discount window the use of which may provide temporary relief but serves as a double edge sword by further feeding the name and reputational crisis. While a literature review on the topic also suggest cash conservation approaches by a re-alignment of businesses and a restructuring of resources, these last two solutions assume that the bank in question would actually survive the crisis to see the end of re-alignment and re-structuring exercise.

Liquidity Reserves: Real or a Mirage

A questionable assumption that often comes up when we review Liquidity Contingency Plans is the availability or usage of Statutory Liquidity and Cash Reserves held for our account with the Central Bank. You can only touch those assets when your franchise and license is gone and the bank has been shut down. This means that if you want to survive the crisis with your banking license intact there is a very good chance that the 6% core liquidity you had factored into your liquidation analysis would NOT be available to you as a going concern in times of a crisis. That liquidity layer has been reserved by the central bank as the last defense for depositor protection and no central bank is likely to grant abuse of that layer.

Figure 2 Liquidity Risk and Liquidity Run Crisis

As the Bear Stearns case study below illustrate the typical Liquidity crisis begins with a negative event that can take many shapes and forms. The resulting coverage and publicity leads to pressure on not just the share price but also on the asset portfolio carried on the bank’s balance sheet as market players take defensive cover by selling their own inventory or aggressive bets by short selling the securities in question. Somewhere in this entire process rating agencies finally wake up and downgrade the issuer across the board leading to a reduction or cancellation of counterparty lines. Even when lines are not cancelled given the write down in value witnessed in the market, calls for margin and collateral start coming in and further feed liquidity pressures.

What triggers a Name Crisis that leads to the vicious cycle that can destroy the inherent value in a 90 year old franchise in less than 3 months. Typically a name crisis is triggered by a change in market conditions that impact a fundamental business driver for the bank. The change in market conditions triggers either a large operational loss or a series of operation losses, at times related to a correction in asset prices, at other resulting in a permanent reduction in margins and spreads. Depending on when this is declared and becomes public knowledge and what the bank does to restore confidence drives what happens next. One approach used by management teams is to defer the news as much as possible by creative accounting or accounting hand waving which simply changes the nature of the crisis from an asset price or margin related crisis to a much more serious regulatory or accounting scandal with similar end results.

Figure 3 What triggers a name crisis?

The problem however is that market players have a very well established defensive response to a name crisis after decades of bank failures. Which implies that once you hit a crisis the speed with which you generate cash, lock in a deal with a buyer and get rid of questionable assets determined how much value you will lose to the market driven liquidation process. The only failsafe here is the ability of the local regulator and lender of last resort to keep the lifeline of counterparty and interbank credit lines open. As was observed at the peak of the crisis in North America, UK and a number of Middle Eastern market this ability to keep market opens determines how low prices will go, the magnitude of the fire sale and the number of banks that actually go under.

Figure 4 Market response to a Name Crisis and the Liquidity Run cycle.

The above context provides a clear roadmap for building a framework for liquidity risk management. The ending position or the end game is a liquidity driven asset sale. A successful framework would simply jump the gun and get to the asset sale before the market does. The only reason why you would not jump the gun is if you have cash, a secured contractually bound commitment for cash, a white knight or any other acceptable buyer for your franchise and an agreement on the sale price and shareholders’ approval for that sale in place. If you are missing any of the above, your only defense is to get to the asset sale before the market does.

The problem with the above assertion is the responsiveness of the Board of directors and the Senior executive team to the seriousness of the name crisis. The most common response by both is a combination of the following

a) The crisis is temporary and will pass. If there is a need we will sell later.

b) We can’t accept these fire sale prices.

c) There must be another option. Please investigate and report back.

This happens especially when the liquidity policy process was run as a compliance checklist and did not run its full course at the board and executive management level. If a full blown liquidity simulation was run for the board and the senior management team and if they had seen for themselves the consequences of speed as well as delay such reaction don’t happen. The board and the senior team must understand that illiquid assets are equivalent of high explosives and delay in asset sale is analogous to a short fuse. When you combine the two with a name crisis you will blow the bank irrespective of its history or the power of its franchise. When the likes of Bear, Lehman, Merrill, AIG and Morgan failed, your bank and your board is not going to see through the crisis to a different and pleasant fate.

Like this:

In late 2008, the The CAS, CIA, and the SOA’s Joint Risk Management Section funded a research report about the Financial Crisis. This report featured nine key Lessons for Insurers. Riskviews will comment on those lessons individually…

4. Insurers should establish a robust liquidity management system to ensure that they have ample liquidity under stress scenarios.

The only trouble with this advice it that it is totally unneeded. That is because almost all cases of insurer problems with liquidity, those problems were preceded by a loss that significantly exceeded management expectations for a worst loss.

So it would not have made a difference whether those insurers planned more for liquidity, those plans would have been inadequate.

Insurers are generally cash flow positive. Liquidity is only ever a problem if that changes drastically. Even the “runs on the bank” that have occured on insurers have followed large losses.

So this advice sounds nice, but is actually unnecessary. If insurers properly anticipate extreme losses, then they will be prepared to pay those losses without triggering problems.

That is because they will:

Price for the losses so that they have sufficient income to pay the losses.

Only accept as much of the risks that might trigger extreme losses as they can afford and spread effectively.

Those are fundamental risk management tasks. If they are done properly, liquidity management is relatively trivial. It consists of remembering not to invest the funds you have on hand to pay those extreme claims in instruments that are illiquid or or widely fluctuating value.

Seems like a good rule in general. One that many insurers forget after many years of positive cashflows.

The events of the past three years are unprecedented in almost all of our lifetimes. One needs to go back and look at how much was happening in such a short time to get an appreciation of how difficult it must have been to be in the hot seats of government, central banks and regulators, especially during the fall of 2008.

On the other hand, it is pretty easy, with 20-20 hindsight, to point to events that should have made it clear that something bad was on its way.

The timeline that is posted here on Riskviews is an amalgam from 5 or 6 different sources, including the BBC, Federal Reserve and Wikipedia. None of them seemed to be very complete. Not that this one is. My personal biases left out some items from all of the sources.

Let us know what was left out that is important. This timeline was created over a one year period and there was little effort to go back and pick up items that did not seem important at the time, but that later were found to be early signals of later big problems.

The reaction that I have had when I used this timeline to make a presentation about the Financial Crisis is that it is pretty unfair to go pointing fingers about actions taken during the fall of 2008. When you look at the daily earth shaking events that were happening, it is really totally overwhelming, even a year later. If the events that occured daily were spread out one per month, then perhaps a case could be made that “they” should ahve done better.

Going back much further, I am not willing to be quite so kind. This crisis was manufactured by collision of two deliberate government policies – home-ownership for all and deregulation of financial markets. That collision was preventable. Neither policy had to be taken to the extreme that it was taken – to what looks now like an absurd extreme in both cases.

And in addition, the financial firms themselves are far from blameless. Greenspan’s belief that the bankers were capable of looking out for their shareholder’s best interest was correct. They were capable.

Read the history. See what happened. Decide for yourself. Let me know what I missed.

Like this:

When you substitute counterparty risk for another risk, you are essentially bringing their entire balance sheet proportionately onto yours. Counterparty due diligence is key. Collateral agreements are important. Some would say that collateral agreements brought down the banks that failed and AIG that was rescued, but from the counterparty point of view… In addition to traditional credit analysis that is mostly backward looking, insurers should try to understand the approach to risk taking of their counterparties so that they can become comfortable with the risks that they may take in the future. The counterparty exposure that exists right now may not be representative of the size of the exposures right after a major loss event. Examination of those potential exposures and the potential losses to the reinsurer in a major loss event should be studied and factored into risk and reinsurance decisions.

This means plotting the level of obligation from the counterparty in the event of an extremely adverse scenario. That is when the idea of taking on a proportionate share of the counterparties balance sheet takes on significant importance. The degree to which the counterparty is concentrated in that particular risk becomes key. That is not information that is available from just looking at the rating of the counterparty. You must know and understand the other obligations of the counterparty to know the degree to which they are at risk from the type of event that you are offsetting (not transferring see Bad Labels ).

This means that a stress test becomes most important. The stress test will look at (1) the amount of gross loss, (2) the amount due from the counterparty under the stress scenario in the form of a claim, a reserve credit, or collateral and (3) the degree to which the stress scenario impacts the ability of the counterparty to make good on their obligations. As was seen during the financial crisis, the liquidity of the counterparty under stress may well be the constraint. If your firm does not have the liquidity to easily pay the gross losses under that are due in cash, then you are relying on the counterparty as a source of liquidity.